Why Apple's iPad Is Floundering

Summary

While Apple's iPhone continues to grow, sales of the iPad have declined for two straight quarters.

Tablets are becoming a commodity, much like PCs, and the best that Apple can hope for in the long-term is a Mac-like market share.

The iPhone representing more than half of Apple's revenue is the biggest risk facing the company.

While the iPhone continues to sell like gangbusters for Apple (NASDAQ:AAPL), the iPad has begun to struggle. For the past two quarters unit shipments have declined, with a 16% year-over-year decline in Apple's second quarter followed by a 9% decline in the third quarter. Apple remains the market leader, but why exactly is the iPad floundering?

Tablets vs. smartphones

There are two important differences between the tablet market and the smartphone market that help explain why Apple's iPad is starting to struggle while the iPhone is doing fine.

First, the iPad doesn't just compete with other tablets, it competes with low-end laptops and 2-in-1 devices as well. The decline of the PC market over the past few years was at least partially the result of the rise of tablets, but tablets are really just another form of a PC. The desktop is the least portable and most powerful, the laptop is a compromise between portability and power, and the tablet sacrifices versatility and power for mobility.

Just like the rest of the PC market, then, tablets will eventually become commoditized, if they haven't already, and average prices will continually decline. Apple's strategy with its Mac is to sell a premium product at a premium price, and this limits Apple's market share while maximizing profitability. Apple could compete on price, but it wouldn't make any sense to do so from a profitability standpoint.

I suspect that Apple will go the same route in the tablet market. Apple will sell its iPads at high prices, capturing a small part of the overall market while earning a large part of the overall profits. Apple had a 26.9% share of the tablet market in the second calendar quarter, down from 33% in the same period last year, so this trend is already starting to play out.

Samsung (OTC:SSNLF), the number two player in the tablet market, also saw its market share decline from 18.8% to 17.2% during the second quarter, although unit shipments rose slightly. Samsung sells tablets at a variety of price points, from the $500 Galaxy Tab S to smaller 7" tablets priced below $200. Apple's latest iPad Mini costs more than twice this, so it's not surprising that Samsung's market share held up better than Apple's.

Who's taking this market share from Apple and Samsung? Plenty of low-cost competition. The percentage of the tablet market attributed to the top 5 vendors shrank from 63% to 55% year-over-year in the second quarter. Nearly half of the global tablet market is split between companies with less than a 2% market share.

Over time, I expect the tablet market to consolidate like the PC market has. But it will be the low-cost vendors, like Lenovo (OTCPK:LNVGY), which grew its market share from 3.3% to 4.9% in the second quarter, that manage to win the lion's share of the market. Lenovo, the world's largest PC seller, has been looking to mobile devices to fuel growth, and its selection of both Android tablets and Windows tablets and convertible devices seem to be resonating with consumers.

The frantic growth of the tablet market has slowed dramatically, and companies can no longer bank on rapidly growing demand to drive sales. Instead, they'll need to compete on price, and that's something that Apple is unlikely to do.

Smartphones are becoming commoditized as well, but unlike tablets they don't compete directly with other form factors. A smartphone can replace a tablet, but not the other way around.

The skewing effect of subsidization

The second important difference between the tablet and smartphone markets is that smartphones are typically subsidized by wireless carriers. This has the effect of making the price difference between the high-end and the low-end smaller, something that the tablet market doesn't enjoy.

An iPhone 5s costs $199 with a two-year contract through Verizon, while off-contract the same phone costs $650. The LG Lucid 3, a mid-range phone, is free with a two-year contract and $150 off-contract.

What would be a $500 price difference is reduced to just $200 with a contract. If subsidization weren't standard practice, I suspect that high-end phones like the iPhone 5s and Samsung's Galaxy wouldn't sell nearly as well.

The tablet and PC markets don't have this feature, and the absolute price difference between the high-end and the low-end in those markets is larger compared to the smartphone market. The cheapest laptop that Apple sells is $900, while there are Windows laptops that sell for less than $300. The cheapest iPad Air is $500, while decent Android tablets sell for less than $200.

If Apple decided to sell a $400 MacBook, the company would probably win a bunch of PC market share. But margins would also decline, and Apple would be no different than companies like HP and Dell. Instead, Apple keeps prices high and limits its market share, and that's exactly what's happening with the iPad. I suspect that Apple's tablet market share will continue to decline.

Conclusion

Apple's iPad is struggling because the tablet market is a lot like the PC market. Apple sells a premium product, and as lower priced tablets get better Apple's position in the tablet market will likely start to look like its position in the PC market. Growth in the tablet market could still drive iPad sales higher, but Apple's market share will ultimately be limited. This means that the iPhone will continue to represent the bulk of Apple's revenue, 53% during the most recent quarter, and this lack of diversification is the biggest risk facing the company going forward.

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